Understanding 401(k) Withdrawal Rules

What do you have planned for your golden years? Having enough money to live comfortably and meet your goals for retirement often starts with your employer-sponsored 401(k). This valuable financial tool helps you achieve your financial goals for retirement. Contributions are deducted from your paycheck before taxes and grow tax-deferred throughout your career.

When used responsibly, your 401(k) can be accessible before retirement for any reason or if you experience financial hardship. However, the IRS has strict rules regarding how much and when this money can be withdrawn from your account, and what administrative or investment fees may apply.

To help you understand these rules, and learn how withdrawing from your 401(k) Ascendant Financial can provide both educational and advisory services. We can show you how to strategically access funds available to you through Infinite Banking and your 401(k) withdrawals. 

To get a head start on the educational component, keep reading this article to learn the basics of 401(k) withdrawal rules and considerations and how it should be used as part of your financial and estate planning.

What Are the Rules for Withdrawing From a 401(k)?

In most cases, you can only withdraw from your 401(k) account if at least one of the following happens:

• You become disabled and need the cash for medical needs
• You pass away (your beneficiary may have access to these funds)
• Your plan is terminated or replaced
• You are 59½ years old
• You have severe financial hardship

If you don’t meet these requirements (and their qualifying factors), you may still be eligible to withdraw the funds, but with certain caveats:

Age Requirements for Withdrawal 

Your 401(k) funds are available to you, penalty-free, after you turn 59½. Some 401(k) plans allow you to withdraw from your account earlier, but they will be subject to additional fees, including a 10% penalty. Regardless of your age, all 401(k) withdrawals will be added to your taxable income. 

The 10% Penalty 

A common mistake people make is withdrawing too early and being surprised by the 401(k) withdrawal tax penalty. Early withdrawals from your 401(k) before you’re 59½ are subject to a 10% penalty fee, in addition to your income tax paid. This is a fee charged by the U.S. Internal Revenue Service (IRS) to discourage people from taking their money out too early. 

For example, if you withdraw $10,000 from your 401(k) at age 50, and you’re in a 22% tax bracket, you’ll pay:

• $2,200 in income tax
• $1,000 early withdrawal penalty
• $3,200 total

Some situations can earn you an exemption from the 10% penalty. These may include:

• If you become disabled
• If you pass away
• If you retire at 55 or older
• If you incur medical expenses that are over 7.5% of your adjusted gross income
• You receive a Qualified Domestic Relations Order (like a divorce settlement)
• You need the cash for birth or adoption expenses (up to a certain amount)
• If you’re called to active military duty 

To learn if you qualify for any of the above penalty exemptions, talk to your financial advisor.

Tax Implications

Early 401(k) withdrawals are treated as taxable income. This will be added to your gross income rate and taxed at your current income tax rate (or could bump you to the next tax bracket). This means if your federal tax bracket is 22%, you’ll pay $2,200 on a $10,000 withdrawal. In addition, some states will charge state income tax on your withdrawn amount. 

Tax laws are constantly evolving, and changes could significantly impact the tax implications of your withdrawals. For example, changes in tax brackets and rates or new legislation might introduce more exceptions for penalty-free early withdrawals or modify Required Minimum Distribution (RMD) ages.

To help a recent Ascendant Financial client mitigate the tax consequences of withdrawals, our advisors helped them roll their 401(k) into a Roth Individual Retirement Account (Roth IRA) during a low-income year. They paid taxes on this amount up front, which secured tax-free growth for their 401(k) and won’t trigger income tax when withdrawn later. 

Ready to take control of your financial future?

Speak with an Ascendant Financial Advisor today and start building a strategy that protects your legacy.

Should You Book a Call?

Exceptions to the 401(k) Withdrawal Penalty

Several exemptions may allow you to withdraw from your 401(k) account before retirement. Here are three of the most common exemptions:

401(k) Hardship Withdrawals

Sometimes the unexpected happens, and you have an “immediate and heavy financial need.” In these cases, you may be permitted a 401(k) hardship withdrawal that is exempt from the 10% penalty. This money is permanently withdrawn from your account (not a loan) and doesn’t need to be paid back. 

Examples of situations that may qualify for a hardship withdrawal include:

• Unexpected medical expenses (that exceed 7.5% of your adjusted gross income)
• Funeral expenses for a family member
• Payments to prevent eviction or foreclosure of your primary residence
• Costs to repair damage to your home

You are required to demonstrate this urgent financial need. The details of the necessary proof and documentation will be outlined in your policy and must meet IRS standards. If approved, you will only be permitted to withdraw the amount to satisfy your exemption need and no more. Your financial advisor can help you understand if you qualify for a hardship withdrawal. 

Separation from Employment 

If you leave your job to retire early (over the age of 55, but under 59½), you may be allowed penalty-free 401(k) withdrawals from your account. This is known as the “Rule of 55.” If you leave your job during your 55th calendar year (or 50 years for some public service employees), you can begin withdrawing from your 401(k) without the 10% penalty. Your withdrawals will, however, be treated and taxed as income.  

A recent Ascendant Financial client retired at 56 and used the Rule of 55 to leave their job and access their 401(k) penalty-free. With our financial guidance, they carefully withdrew funds to stay within a lower tax bracket. This helped them cover their essential living expenses while delaying Social Security benefits. 

Qualified Domestic Relations Order (QDRO) 

If your retirement funds need to be split between an ex-spouse or dependent, you may qualify for a 10% penalty waiver. For example, if you get divorced, you can withdraw and split amounts, as determined by your divorce agreement, and not be charged a penalty, even if you’re under the 401(k) withdrawal age. 

Before any QDRO exemption is approved, it must be accepted by the courts and your plan administrator. The funds withdrawn will be added to each recipient’s income for that tax year and will be taxed at their federal and state rates. 

Strategies to Avoid 401(k) Withdrawal Penalties 

In addition to the exemptions listed above, there are other strategies to minimize fees and taxes on early 401(k) withdrawals. The four most common strategies include:

Loans vs. Withdrawals

A policy withdrawal is different from a loan. In a withdrawal, you permanently withdraw the funds and are often subject to a 10% penalty and income taxes. With 401(k) loans, you are borrowing money from your account with the intent to pay it back. The amount you can borrow may be subject to your plan limits and IRA rules (typically up to $50,000 or 50%, whichever is less).

Your 401(k) loan must be paid back within five years, unless you agree otherwise with your plan provider. If using your loan to purchase a primary residence, you may be granted a longer repayment term. In some cases, you’ll need spousal or domestic partner consent for the loan. 

Converting to an Individual Retirement Account (IRA)

For greater flexibility in withdrawal options, consider rolling your 401(k) into an Individual Retirement Account (IRA). An IRA is an account you open and manage yourself. Typically, contributions are tax-deductible. Here are the options and benefits you usually get with an IRA:

• Substantially Equal Periodic Payments (SEPP): Your account may allow you to withdraw a fixed amount over your lifetime, exempt from the 10% penalty, even before your age of retirement. You must continue with your SEPP for at least five years or until you turn 59½. 
• No “Rule of 55”: The Rule of 55 only applies to your most recent employer. However, if you roll your 401(k) into an IRA, you can get early access to the money in this account, regardless of your age or employment status. 
• Broader investment options: Because you have greater control over your account, you can choose to invest in stocks, bonds, ETFs, mutual funds, and more, based on your investment knowledge and risk tolerance. You may choose these investment options to better manage growth and control your liquidity. 
• Option to pay taxes now rather than later: When you roll your retirement account into a Roth IRA, you can pay your income taxes now and then withdraw in the future, income tax-free. This can help you minimize taxes over time.   
• Manage tax brackets: With an IRA, you can control when and how much you withdraw from your account to control your tax brackets. This allows you to plan small distributions to stay within your current tax bracket. 

If you have the financial acumen and want greater control over your retirement accounts and cash liquidity, rolling your 401(k) into an IRA may be a wise financial decision. 

Converting to a Roth IRA

At age 73, you are required to withdraw a Required Minimum Distribution (RMD) from your 401(k). If you don’t, you may be subject to 401(k) distribution rules, including a severe financial penalty(currently 25% of the amount not withdrawn). To avoid this, convert a portion of your 401(k) to a Roth IRA before RMDs begin. This will incur taxes on the conversion, but future withdrawals from a Roth IRA will be tax-free. 

Considerations for Withdrawal Timing 

The timing of 401(k) withdrawals can have a significant impact on the amount you receive and how much you’ll owe in penalties and taxes. Consider the following strategies to minimize withdrawal costs:

• Wait until after 59½: To avoid the 10% early withdrawal penalty completely, wait until the age of retirement before you withdraw your retirement funds. Your withdrawal will still be subject to federal and state income taxes.
• Spread withdrawals over multiple years: If you are subject to income taxes on your withdrawals, spread your withdrawals over multiple tax years so they don’t push you into a higher tax bracket. 
• Coordinate withdrawals with income: In years you have a lower income, consider pulling more from your retirement account. 
• Rule of 55: If you can wait to leave your job until you’re at least 55 years old, the 10% early withdrawal penalty will be waived.   
• Time withdrawals with a move: If you plan to move to a state with lower or no state income tax, wait to withdraw until after you move to save taxes. 

The most cost-effective option is to wait until you’re 59½ to withdraw from your 401(k). Alternatively, you could look for other sources of income if you need an infusion of cash before retirement. 

For example, if you have a participating whole life insurance plan and use the Infinite Banking Concept, you may be eligible to get a loan against the cash value of your policy to use for any purpose, at any time. This loan comes with more flexible repayment terms and interest rates than traditional loans, and isn’t subject to penalty fees or counted as taxable income, like 401(k) withdrawals.

Learn more about how to use the Infinite Banking Concept in this free, on-demand webinar. 

The Role of 401(k) Withdrawals in Financial Planning

Your 401(k) should be included in your long-term financial planning. How you use the value of your 401(k) and other retirement savings accounts will directly impact your tax burden, cash flow, and retirement financial security. 

Work with an Ascendant Financial advisor for help creating your personalized financial strategy, including planning how you want to access funds before and during retirement. In addition to your retirement accounts, you can access funds from your whole life insurance policy to fund your retirement through a tax- and penalty-free loan. When you borrow money this way, you use the cash value of your life insurance policy as collateral while your money stays in your account and continues to benefit from compounding growth. As a bonus, the interest you pay on your loan goes back into your policy, further accelerating your growth. 

Your life insurance policy also provides a tax-free death benefit to your beneficiaries, helping secure their generational wealth and getting a head start on their own financial and retirement planning. 

However, Infinite Banking works best with a properly structured whole life insurance plan. Your Ascendant Financial advisor can help you set up your plan for your budget and financial goals, so you can optimize retirement planning and ensure your funds are managed appropriately. Your advisor also provides educational resources to help you understand how to use Infiniate Banking to “become your own banker,” limiting your reliance on banks and unpredictable market conditions. 

Are you in Canada? Learn more about retirement planning in Canada and how Canadians can withdraw from their RRSP without paying tax. 

When Is the Best Time to Withdraw From My 401(k)?

When and how much you withdraw from your 401(k) retirement account will make a significant impact on your finances. Early 401(k) withdrawals are subject to a 10% penalty in addition to applicable federal and state income taxes. While there are some exceptions to this penalty (such as financial hardship or medical needs), this 10% penalty can significantly decrease the amount you receive to pay for your retirement.

Retirement and estate planning are essential to ensure you can meet your financial obligations and needs over your lifetime while mitigating unnecessary fees and expenses. Personalized financial planning can help you take control of your financial future. 

An expert Ascendant Advisor recommends that, “to stay ahead, it’s crucial to adopt strategies that shift funds from ‘forever taxable’ accounts, like 401(k)s, to ‘never taxable’ ones, such as Roth IRAs. Regularly consulting with a knowledgeable advisor ensures you’re prepared to adapt as laws change.” 

Ascendant Financial’s approach emphasizes personalized strategies that integrate tools like the Infinite Banking Concept (IBC). By leveraging dividend-paying whole life insurance policies, clients gain access to tax-free cash value growth and penalty-free liquidity through policy loans. This creates a flexible financial foundation, allowing clients to manage withdrawals strategically while minimizing tax burdens. Additionally, the team’s expertise in tax planning ensures that clients can align their withdrawal strategies with their overall financial goals, optimizing both short-term needs and long-term wealth preservation. 

If you’re looking for an alternative to withdrawing from your 401(k) account, work with an Ascendant Financial Advisor to grow wealth & plan for retirement.

Frequently Asked Questions About 401(k) Withdrawals

What are the rules for withdrawing from a 401(k)?

You can begin withdrawing funds from your 401(k) account as soon as you turn 59½. These withdrawals will count as income and are subject to federal and state income taxes. Your account may allow for early withdrawals, but will be subject to a 10% early withdrawal fee (in addition to being taxed as income). There are circumstances under which you can apply for a penalty waiver (such as severe financial hardship). Exceptions can be discussed with your financial advisor or plan administrator. 

Can I withdraw 100% of my 401(k)?

Yes, you can withdraw your full 401(k) balance, but in most cases, it is not recommended. Since all withdrawals are subject to income taxes, withdrawing large amounts can put you into a higher tax bracket, and you’ll pay more in income taxes. Remember, anytime you withdraw from your account, you also lose any compounding growth it could earn over time. Unless it’s necessary to make a large withdrawal, spread your withdrawals out over your lifetime to keep your tax bracket low.

At what age can you withdraw from a 401(k) without paying taxes?

All withdrawals will be counted towards your taxable income, regardless of when you withdraw the funds. Withdrawals before age 59½ are also subject to a 10% penalty. To avoid paying taxes, you might consider moving your 401(k) into a different retirement account, such as an Individual Retirement Account (IRA). IRA accounts offer more flexibility in withdrawals at any age. 

Search

Popular Posts

• 
  Understanding 401(k) Withdrawal Rules
  What do you have planned for your golden years? Having enough money to live comfortably and meet your goals for retirement often starts with your… Read more: Understanding 401(k) Withdrawal Rules
• 
  Is Infinite Banking Right for You? Pros, Cons, and Insights
  Are you ready to take the first step toward financial control and independence? Canadians from across the country are learning how the Infinite Banking Concept… Read more: Is Infinite Banking Right for You? Pros, Cons, and Insights